Lecture 1: Capital Structure: Lorenzo Bretscher

Lecture 1: Capital Structure
Lorenzo Bretscher
Finance II - Spring 2022
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Quick Review
1. The total risk of an asset can be broken down into two categories. What are
those?
idiosyncratic risk (exclusive to the company - can be eliminated)

and systematic risk (market/general risk)
2. What is the largest portfolio that we can invest in?
3. What is the proportion of systematic and idiosyncratic risk in the total risk of
the market portfolio?
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Quick Review
4. What does beta measure?
5. In the following statement correct? The beta of a portfolio is the

equal-weighted sum of the betas of individual securities in the portfolio.
6. How would you estimate the cost of capital of a stock with β = 1.5?
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Big Picture
Finance
Capital Financing
Budgeting Decisions
Risk &
Return
Present Value Investment Cash Flows Capital WACC

Rules Structure
How much are What rules do How is revenue How much What is the cost
future cash flows firms use making converted into debt should of capital
worth today ? investment decisions? cash flows? company have? of the company ?
Portfolio Theory CAPM

How do investors How can asset
trade off returns be modeled?
risk and return?
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Big Picture
Capital budgeting
I Decisions about the operations of the company
I What investments should be funded?
Financing decisions
I Decisions about the capital structure of the company
I How should a project be funded?
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Outline of Today
1. Introduction to capital structure
2. Capital structure in perfect capital markets

I Modigliani Miller Proposition # 1
3. Capital structure in imperfect capital markets

I Capital structure and taxes
I Capital structure and costs of financial distress
F Bankruptcy costs
F Other costs
I Capital structure and trade-off theory
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Introduction to Capital Structure
How do firms pay for their investments?
Equity financing
I Private firms: founders and others contribute money
I Publicly-traded firms: shareholders contribute money in the initial public
offering (IPO); subsequently, more funds can be raised in a seasoned equity
offering
I Retained earnings: shareholders money gets “plowed back in”
Debt financing
I Bank loans
I Corporate bonds
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Introduction to Capital Structure
Capital structure: a firm’s mix of securities
Assets (V) Debt (D)

Equity (E)
The BIG question - does capital structure matter?
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A Yogiism
Yogi ordered a pizza. The waitress asked “How many

pieces do you want your pie cut?”
Yogi responded, “Four. I don’t think I could eat eight.”
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Does Capital Structure Matter?
Does each firm have an optimal capital structure – capital structure that
maximizes firm’s market value?
When firms issue both debt and equity, we can decompose the market value
of the firm into the market values of their debt and equity
MV of the firm = MV of debt + MV of equity
Why should stockholders, who only own equity, care about maximizing the
market value of the firm?
If we ignore default risk then any increase or decrease in firm value becomes
an identical increase or decrease in the market value of equity
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Outline of Today


F Bankruptcy costs
F Other costs
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Capital Structure in Perfect Capital Markets
Can a change in capital structure change the market value of the firm?
Example:
The Saw Company is reviewing its capital structure. It has no debt, pays no
taxes and has access to perfect capital markets. The interest rate on risk-free
debt is 10%. The company has 100 shares outstanding which trade at $20
per share. It has no investment opportunities, so the operating income is fully
paid out to stockholders as dividends. In each year, the company’s operating
income can take one of three possible values depending on future market
conditions
3 Expansion : $300
8
1
2
Neutral : $250
1
8
Recession : $100
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Example: Perfect Capital Markets
Mr. Modigliani (the company’s CEO) has come to the conclusion that
shareholders would be better off if the company had equal proportions of
debt and equity. He proposes to issue $1, 000 of debt at the risk-free rate of
10% and use the proceeds to buy back 50 shares.
I Reduction in equity value
(100 − 50) × $20 = $1, 000
I Interest payment on debt
0.1 × $1, 000 = $100
Side question: Can the Saw company really issue debt at the risk-free
rate of 10%?
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Earnings Before Interest - Interest Expense

EPS =
Shares Outstanding
Mr. Modigliani argues as follows: “It
can be seen from this picture that the
effect of leverage depends on the
company’s operating income. If this is
greater than $200, EPS are increased
by leverage and our shareholders are
better off. If it is less than $200, EPS
are reduced by leverage. Since on
average we expect operating income to
be $250, which is above the critical
level of $200, shareholders are better
off with the levered capital structure.”
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Ms. Miller, who recently graduated from LBS is on the fast track to become
the next CEO, counters Mr. Modigliani’s argument as follows: ”Leverage will
help our shareholders as long as operating income is above $200. Your
argument ignores the fact that shareholders have the alternative of borrowing
on their own account. For example, suppose an investor borrows $20 and
invests a total of $40 in two unlevered Saw shares. This investor has to put
up only $20 of his own money
What is the return on their $20 investment?
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Both the cost and the payoff from the two strategies are the same
1. Buying 1 share of the levered company
2. Buying 2 shares of the unlevered company and borrowing 20$
⇒ An investor is not receiving anything from corporate leverage that she could
not receive with her homemade leverage
Modigliani Miller (MM) Proposition # 1
In frictionless (=perfect) capital markets, capital structure is irrelevant

The MV of the unlevered firm is the same as the MV of the levered firm
However, capital structure does affect the value and the risk of the
components (equity & debt)
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MV of the unlevered firm
VU = 100 × $20 + |{z}

$0 = $2, 000
| {z }
equity debt
MV of the levered firm
VL = 50 × $20 + $1, 000 = $2, 000

| {z } | {z }
equity debt
I Shareholder’s total wealth
50 × $20 + 50 × $20 = $2, 000

| {z } | {z }
income from share repurchases value of remaining equity holdings
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Outline of Today


F Bankruptcy costs
F Other costs
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Mr. Modigliani is not ready to give up yet: “The company can borrow up to
$1, 000 at a rate of 10%, which implies it can make 12.5% − 10% = 2.5%
extra profit by borrowing against its assets. Thus, even if the share price
remains the same, the expected ROE increases from 12.5% to 15%, which
benefits shareholders.”
Normal
Recession Times Expansion Expected
100% Equity
Return on Equity (ROE) 0% 12.5% 15% 12.5%
50% Equity and 50% Debt

Return on Equity (ROE) 0% 15% 20% 15%
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Recall that the return on a portfolio of two securities is equal to a weighted

average of the returns on the individual securities
rp = γA rA + γB rB
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The return on assets (ROA) is equal to a weighted average of the return on

equity (ROE) and the return on debt (ROD)
E D
rA = rE + rD
E +D E +D
Normal
Recession Times Expansion Expected
100% Equity
Return on Equity (ROE) 5% 12.5% 15% 12.5%
Return on Assets (ROA) 5% 12.5% 15% 12.5%
50% Equity and 50% Debt

Return on Equity (ROE) 0% 15% 20% 15%
Return on Debt (ROD) 10% 10% 10% 10%
Return on Assets (ROA) 5% 12.5% 15% 12.5%
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The return on equity (ROE) of a levered firm increases with the market
debt-to-equity (D/E) ratio
D
rE = rA + (rA − rD )
E
This increase depends on the spread between the return on assets and the
return on debt
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D
E
17%
16%
15%
14%
13%
12%
11%
10%
9%
8%
0 0.5 1 1.5 2
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E D
rA = rE + rD
E +D E +D
The firm’s cost of debt is lower than its cost of equity. Wouldn’t it be
optimal to substitute the cheaper debt for the more expensive equity?
This would lower the firm’s weighted average cost of capital and increase its
value
No! The firm’s weighted average cost of capital, rA , is independent of capital

structure
D
I Increasing E +D increases the weight on the ”cheaper” debt but it also increases
the cost of equity rE
I The second effect exactly offsets the first with the overall effect being that the
weighted average cost of capital remains unchanged
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We still have not completely resolved the dispute between Mr. Modigliani
and Ms. Miller. While Ms. Miller made the convincing case that the value of
the company is independent of its capital structure (MM Proposition # 1),
Mr. Modigliani made the convincing case that increasing leverage increases
the expected return on equity (MM Proposition # 2)
Who is right?
Both are right. However, the fact that the expected return on equity
increases with leverage does not mean that shareholders are better off
(contrary to Mr. Modigliani’s first claim). Rather, the expected (or
“required”) return on equity must increase to compensate shareholders for the
increase in risk brought about by the increase in leverage
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Summary: Perfect Capital Markets
Corporate financial leverage:
Does not change firm value
Does change equity and debt value

Does change the distribution of risk and expected return between debt and
equity holders
Does not make the firm riskier

I Does not change firm weighted average cost of capital rA
Does make equity riskier

I Does increase firm cost of equity rE
Can make debt risky (or riskier)

I Can increase firm cost of debt rD
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Summary: Perfect Capital Markets
In frictionless (=perfect) capital markets, capital structure is irrelevant

The MV of the unlevered firm is the same as the MV of the levered firm
However, capital structure does affect the value and the risk of the
components (equity & debt)
The return on equity (ROE) of a levered firm increases with the market
debt-to-equity (D/E) ratio
D
E
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Outline of Today


F Bankruptcy costs
F Other costs
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Importance of MM Propositions
Basic idea is that with no market frictions, investors can duplicate or modify
the capital structures of firms on their own
Therefore, it can not be valuable for firms to repackage their assets for
investors
But were they seriously arguing that capital structure does not matter?
No! Many of the assumptions are questionable approximations to the real

world
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Importance of MM Propositions
If financing policy does affect the firm value it will do so for one or more of
the following reasons:
1. Firms and shareholders pay taxes
2. Firms and shareholders face transactions and/or information costs
3. Firms and shareholders face bankruptcy costs (or, more generally, costs of
financial distress)
Trade-off theory relaxes the assumptions of “no taxes” and “no costs of
financial distress”
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Outline of Today


F Bankruptcy costs
F Other costs
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Capital Structure and Taxes
Under the U.S. corporate tax code there is an important difference in the way
in which interest and dividends are treated
I Historically, interest is regarded as a cost of doing business and as a result is

tax deductible
I By contrast, dividends are treated as a return to the firm’s owners and are
therefore not tax deductible
Bias towards debt finance!
I Holding before-tax cash flows fixed, debt finance reduces a firm’s taxable
income, resulting in higher after-tax cash flows
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Capital Structure and Taxes
MM Proposition # 1
The value of the pizza does not depend on how it is sliced
I “Pizza” = assets, “Slices” = debt and equity
But, there is a third slice! The government
Modified MM Proposition # 1
The market value of a levered firm (VL ) equals the market value of an
unlevered (VU ) firm plus value of interest tax deductibility
VL = VU + PV of Tax Shields
Financial leverage can increase firm value!
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Another Way To Think About This
PV of
VU VU VL Tax Shields
without taxes after taxes after taxes
paid paid
The first pizza is the value of an all-equity firm that pays no corporate taxes
The second pizza is the value of an all-equity firm that pays corporate taxes
The third pizza is the value of a levered firm that pays corporate taxes
I Issuing debt allows a firm to reduce its taxable income and, thereby, its tax
payments
I The firm’s value increases by PV of the tax shields
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Example # 1: Capital Structure and Taxes
Firms U and L are identical in almost all respects. They both have a
corporate tax rate of 30% and an operating income of $100 per year forever
with certainty. The only difference is that firm U has no debt, while firm L
has issued $200 in perpetual debt at the risk-free rate of 10%
What are the market values of firm U and L?
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What does this imply for value maximization?

What is the optimal capital structure?
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Technotronics Inc. has 100 shares outstanding. The firm has no debt, a
corporate tax rate of 34%, and its operating income is $757.58 per year
forever with certainty. The risk-free interest rate is 10%
What is the firm’s market value? Its stock price?
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Suppose Technotronics issues perpetual debt with an annual coupon payment

of $100 and uses the proceeds to buy back equity
What is the firm’s market value and stock price now?
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Summary
Having debt creates value

I Reduces your tax bill
So “PV of the FCF” understates a levered firm’s value

I NOPAT is “too low” since it ignores interest expense
What to do? Either

1. Adjust the cash flows (“Adjusted Present Value”(APV))
2. Adjust the discount rate (“Weighted Average Cost of Capital” (WACC))
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Outline of Today


F Bankruptcy costs
F Other costs
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Capital Structure and Costs of Financial Distress
Important to distinguish between
1. Business failure (FCF < 0)
2. Bankruptcy
F Division of the cash flows
F Liquidity (can not pay rD)
F Insolvency (D > PV (FCF ))
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Costs of Financial Distress
Bankruptcy is typically not the main problem

I Bankruptcy is a division of the cash flows
I Nevertheless .... dividing-up results in “deadweight costs”
Deadweight costs of financial distress are costs that a non-levered firm would
not face if in the same business situation
1. Bankruptcy costs
i. Direct costs (e.g., legal fees, opportunity cost of management time)
ii. Indirect costs (e.g., reputation, production inefficiencies)
2. Other costs
i. Risk shifting
ii. Debt overhang problem
iii. Inefficient liquidations (“fire sales”)
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Capital Structure and Bankruptcy
Another Modified MM Proposition # 1
The market value of a levered firm (VL ) equals the market value of an
unlevered (VU ) firm plus value of interest tax deductibility minus the costs of
financial distress
VL = VU + PV of Tax Shields − Costs of Financial Distress
Financial leverage can decrease firm value!
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Aside: Defaultable Debt
What do bondholders get if default occurs?
I Promised (maximum) return?

I Realized return?
I Expected return?
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Example: Defaultable Debt
The X Company issues a one-year bond that will sell at par ($100). The
coupon rate paid at the end of the year is $15. If the company goes bankrupt
– 10% chance, the bondholder will get $70 per bond
0.9 $100+$15
0.1 $70
I Promised (maximum) return

$115
− 1 = 15%
$100
I Realized returns
$70
15% & − 1 = 30%
$100
I Expected return
0.9 × 15% + 0.1 × (−30%) = 10.5%
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Example: Defaultable Debt
Suppose now that the bond does not sell at par. Price = $95
I Promised (maximum) return
$115
− 1 = 21%
$95
I Realized returns
$70
21% and − 1 = −26%
$95
I Expected return
0.9 × 21% + 0.1 × (−26%) = 16%
Corporate bond yields are not “expected rates of return” but “maximum rates
of return”
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Outline of Today


F Bankruptcy costs
F Other costs
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Example: Capital Structure and Bankruptcy
The Boxer Company’s cash flows are either $100 or $200 per year forever.
Both scenarios are equally likely. All uncertainty is resolved one year from
now when the first cash flow is received. The company has no debt and the
risk-free interest rate is 10%
What is the market value of the Boxer Company?
Expected operating income (per year)
1 1
× $100 + × $200 = $150
2 2
Market value of firm
$150
= $1, 500
0.1
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Suppose the Boxer Company issues $1, 250 worth of perpetual debt with an
annual coupon payment of $150 and pays out the proceeds to shareholders as
a special dividend
What is the market value of the Boxer Company now?
What is the total wealth of shareholders?
Unlevered Levered
Rec Exp Expected Rec Exp Expected

Operating Income (EBIT) $100 $200 $150 $100 $200 $150
Interest Expense $0 $0 $0 $100 $150 $125
Taxable Income $100 $200 $150 $0 $50 $25
Tax - - - - - -
Net Income $100 $200 $150 $0 $50 $25
MV of equity $1, 000 $2, 000 $1, 500 $0 $500 $250

MV of debt $0 $0 $0 $1, 000 $1, 500 $1, 250
MV of asset $1, 000 $2, 000 $1, 500 $1, 000 $2, 000 $1, 500
Special Dividend $0 $0 $0 $1, 250 $1, 250 $1, 250

Wealth of Shareholders $1, 000 $2, 000 $1, 500 $1, 250 $1, 750 $1, 500
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The market values of the unlevered and levered firms are identical!
Note that debt holders just break even
I Debt holders are compensated with a promised (maximum) yield of
$150
= 12%
$1, 250
I Realized returns
$100
12% & = 8%
$1, 250
I Expected return
0.5 × 12% + 0.5 × 8% = 10%
The MM proposition straightforwardly generalize to the case in which

bankruptcy is possible but is costless
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Suppose if the Boxer Company enters into bankruptcy it must pay a one-time
cost of $11 out of its cash flows. Think of this cost as a lawyer’s fee or
administrative costs to be paid in bankruptcy. The annual coupon payment
remains $150
Assuming debt holders pay a fair price for the debt, what are the proceeds
from the debt issue?
Debt issuance
1
2 × $100 + 12 × $150 1
2 × $11
− = $1, 245
0.1 1.1
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What is the market value of the Boxer Company now?

What is the total wealth of shareholders?
Unlevered Levered
Rec Exp Expected Rec Exp Expected

Operating Income (EBIT) $100 $200 $150 $100 $200 $150
Bankruptcy Cost $0 $0 $0 $11 $0 $5.5
Interest Expense $0 $0 $0 $89 $150 $119.5
Taxable Income $100 $200 $150 $0 $50 $25
Tax - - - - - -
Net Income $100 $200 $150 $0 $50 $25
MV of equity $1, 000 $2, 000 $1, 500 $0 $500 $250

MV of debt $0 $0 $0 $990 $1, 500 $1, 245
MV of asset $1, 000 $2, 000 $1, 500 $990 $2, 000 $1, 495
Special Dividend $0 $0 $0 $1, 245 $1, 245 $1, 245

Wealth of Shareholders $1, 000 $2, 000 $1, 500 $1, 245 $1, 745 $1, 495
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The bankruptcy costs reduce the market value of the Boxer Company by
1
2 × $11
= $5
1.1
The market value of the levered firm
VL = VU − Costs of Financial Distress

$1, 495 = $1, 500 − $5
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Direct Bankruptcy Costs Appear Limited
The Boxer Company incurs legal fees and administrative costs when it enters
into bankruptcy. These are examples of direct bankruptcy costs
Empirical studies suggest that direct bankruptcy costs are rather small,
between 1% and 5% of firms’ value prior to bankruptcy
I Given that the likelihood of going bankrupt for a typical large U.S. firm is less
than 1%, this implies that expected direct bankruptcy costs are less than
0.05% of firms’ value prior to bankruptcy
I Direct bankruptcy costs cannot explain the debt ratios of 30% to 40%
observed in the data
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Indirect Bankruptcy Costs
While direct costs of financial distress are likely to be small, there are
potentially large indirect bankruptcy costs
I Firms may have to sell assets in fire sales

I Firms may lose flexibility if they must continually obtain permission from the
bankruptcy court for any important decision
I Debtholders may try to steer the firm towards investing in relatively safe but
possibly less profitable projects
I Firms may lose customers who think the firm might go out of business
I Suppliers may be reluctant to continue supplies and less willing to grant trade
credit
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Outline of Today


F Bankruptcy costs
F Other costs
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Other Costs of Financial Distress
“Agency conflicts” between debt holders and management (who represents

equityholders’ interests) become amplified when firms enter into financial
distress
I “Risk shifting:” management may invest in risky projects even if these have a
negative NPV
I “Debt overhang problem:” management may be unable to raise new capital for
positive-NPV projects when the firm’s existing debt holders have a senior
claim to the proceeds
“Fire sales:” firms may have to sell assets at inefficiently low prices
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Example: Overinvestment
Bumber-Tifflin, a well-known supplier of paper products, is facing financial

distress. It currently has a loan outstanding of $1m due at the end of the
year, however, at that time, the market value of its assets will only be
$900, 000
To save the firm, Bumber-Tifflin’s managers are considering going into the
lemonade business for a year. This venture has no upfront costs, and with
50% probability the market value of Bumber-Tifflin’s assets will be $1.3m
million. Otherwise the assets will be worth only $300, 000
Should management pursue the new strategy?
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Example: Overinvestment
Shareholders gain at the expense of debtholders by engaging in risky

strategies when firms are close to financial distress (“gambling with
debtholders’ money”)
This phenomena is sometimes called the asset-substitution problem
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Example: Underinvestment
Suppose that instead of entering the lemonade business, Bumbe-Tifflin

considers steering the company into the origami paper business. For an initial
investment of $100, 000, the firm will realize a risk-free return of 50% at the
end of the year. Assume a risk free rate of 5%
Could Bumber-Tifflin raise $100,000 by issuing new equity?
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Example: Underinvestment
By issuing new equity, Bumber-Tifflin can raise at most
$50, 000
= $47, 619
1 + 0.05
When facing financial distress, some firms may choose not to finance positive
NPV projects
This phenomena is sometimes called the debt overhang problem
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Example: Fire Sales
Suppose that instead of entering new lines of business, Bumber-Tifflin

considers selling some of its machinery and equipment for $25, 000 at the
beginning of the year, the proceeds of which will be distributed as dividends
to equity holders. The only problem is that upon selling the machinery and
equipment, the value of the firm’s assets at the end of the year will only be
$800, 000
Does management have any incentive to execute this transaction?
Yes! Shareholders will get $25, 000 today, instead of $0 in a year
Existing Business New Strategy
MV of Asset $900, 000 $800, 000

MV of Debt $900, 000 $800, 000
MV of Equity $0 $0
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Outline of Today


F Bankruptcy costs
F Other costs
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Capital Structure and Trade-off Theory
Optimal capital structure trades-off tax benefits of debt against costs of

financial distress
I Starting out from a situation where the firm is unlevered, a small increase in
leverage has benefits (tax shields) but virtually no costs as the probability of
financial distress remains negligible
I As leverage increases beyond the point where financial distress is negligible,

the probability of financial distress, and thus the expected costs associated
with it, becomes more and more important
I At some point, the expected costs of financial distress become so large that
the firm value decreases if leverage is increased any further. At this point, the
firm has reached its optimal capital structure.
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Summary
What is the capital structure decision?
Modigliani-Miller: no “frictions”
I Leverage is irrelevant for firm value

I Leverage affects risk/return properties of equity/debt
Frictions
I Taxes: debt “shields” add value

I Costs of financial distress: “deadweight costs” decrease value
F Direct and indirect bankruptcy cots
F Agency conflicts
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Next Week
Lecture:
– Read/Solve "Mariott Corporation: The Cost of Capital"
Seminar:
– Problem Set 1
HAVE A GREAT WEEK!
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Lecture 1: Capital Structure: Lorenzo Bretscher

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Lecture 1: Capital Structure

Finance II - Spring 2022

idiosyncratic risk (exclusive to the company - can be eliminated)

2. What is the largest portfolio that we can invest in?

4. What does beta measure?

5. In the following statement correct? The beta of a portfolio is the

Present Value Investment Cash Flows Capital WACC

Portfolio Theory CAPM

1. Introduction to capital structure

2. Capital structure in perfect capital markets

3. Capital structure in imperfect capital markets

I Capital structure and trade-off theory

How do firms pay for their investments?

Capital structure: a firm’s mix of securities

Assets (V) Debt (D)

The BIG question - does capital structure matter?

Yogi ordered a pizza. The waitress asked “How many

Yogi responded, “Four. I don’t think I could eat eight.”

1. Introduction to capital structure

2. Capital structure in perfect capital markets

3. Capital structure in imperfect capital markets

I Capital structure and trade-off theory

I Reduction in equity value

(100 − 50) × $20 = $1, 000

I Interest payment on debt

0.1 × $1, 000 = $100

Earnings Before Interest - Interest Expense

What is the return on their $20 investment?

Modigliani Miller (MM) Proposition # 1

In frictionless (=perfect) capital markets, capital structure is irrelevant

MV of the unlevered firm

VU = 100 × $20 + |{z}

MV of the levered firm

VL = 50 × $20 + $1, 000 = $2, 000

I Shareholder’s total wealth

50 × $20 + 50 × $20 = $2, 000

1. Introduction to capital structure

2. Capital structure in perfect capital markets

3. Capital structure in imperfect capital markets

I Capital structure and trade-off theory

50% Equity and 50% Debt

Recall that the return on a portfolio of two securities is equal to a weighted

The return on assets (ROA) is equal to a weighted average of the return on

50% Equity and 50% Debt

Modigliani Miller (MM) Proposition # 2

No! The firm’s weighted average cost of capital, rA , is independent of capital

Corporate financial leverage:

Does not change firm value

Does change equity and debt value

Does not make the firm riskier

Does make equity riskier

Can make debt risky (or riskier)

Modigliani Miller (MM) Proposition # 1

In frictionless (=perfect) capital markets, capital structure is irrelevant

Modigliani Miller (MM) Proposition # 2

1. Introduction to capital structure

2. Capital structure in perfect capital markets

3. Capital structure in imperfect capital markets

I Capital structure and trade-off theory

No! Many of the assumptions are questionable approximations to the real

1. Introduction to capital structure

2. Capital structure in perfect capital markets